Defensive attitude could leave investors caught by the rebound

At some stage in the next 12 months it will be dangerous to hold cash and high-yielding defensive stocks. Over the course of the past five years Australian investors have become more defensive than a Geoffrey Boycott innings. In 1967, the English batsman scored an unbeaten double century against India only to be dropped for being too defensive and boring. The same fate awaits investors if they believe the sharemarket has lost its ability to deliver capital gains.

At some stage in the next 12 months it will be dangerous to hold cash and high-yielding defensive stocks. Over the course of the past five years Australian investors have become more defensive than a Geoffrey Boycott innings. In 1967, the English batsman scored an unbeaten double century against India only to be dropped for being too defensive and boring. The same fate awaits investors if they believe the sharemarket has lost its ability to deliver capital gains.

No one can be certain when the Australian sharemarket will snap out of its low-return era. However, when it does happen it will be marked by a robust rally that sustains rather than wilts like all of the rallies that have taken place since the market crashed in 2008. In previous bear markets the first year of the new bull market has delivered significant returns.

When the Australian market bottomed in November 1992, after five years of a secular bear market, the benchmark All Ordinaries index rocketed 49.3 per cent by November 1993. Similarly, when the bourse headed south from 1969 to September 1974, the following 12 months saw equities gain 41 per cent.

A sharemarket analyst, Andrew McCauley, of Veritas Securities, has calculated that when the Australian sharemarket has suffered a negative capital return over a seven-year period, the following three years' return delivered a positive 15.7 per cent compound per annum. For the seven years to June 30, the Australian sharemarket delivered its first negative capital return since the 1970s. If history proves reliable and the All Ordinaries index sticks to the average it would be 6400 by June 2015, still 400 points below the all-time high set in November 2007.

So why do markets bounce so hard after a protracted period of underperformance? First, the sellers have been exhausted. Second, there is a vast amount of money sitting in non-productive assets such as cash and bonds. In Australia's case the bond market is underdeveloped and frightened money finds its way into high-yielding and defensive stocks such as Telstra, the banks, property trusts and healthcare stocks, such as CSL and Ramsay. More recently, stockbrokers have wised up to this trend and offered listed high-yielding debt corporate hybrids and have been swamped by investors. These are quality stocks but have become expensive.

The funding mix for Australian banks has seen cash levels increase from below 40 per cent before the global financial crisis to nearly 55 per cent currently. The 125 basis points cut in official interest rates by the Reserve Bank since late last year has not yet induced investors to withdraw their cash. At this stage the central bank looks like it will only, at best, cut official interest rates by another 25 basis points before the end of the year, however, the competition for deposits will ease seeing returns on cash slide. This could well prove the catalyst for a move into higher risk and more productive assets.

At the top of a multi-year bull run many people claim the market cannot fall because there is simply too much cash around. Eventually, though, when the market does head south there is a realisation the money supporting the market is largely borrowed and the lender wants it back. The crash in 2008 being a prime example. At the bottom of bear markets, though, there are genuinely mountains of cash looking for a home. This money is not borrowed and will switch from safety to risk in relatively quick time. The market begins to rise and people start to climb over each other eager not to miss out.

The naysayers, currently the majority, believe it is different this time. The Western world, led by the Americans and Europeans, cannot bounce back because of the mountains of debt they have accumulated. At the other end of the spectrum, the world's saviour - China - is structurally imbalanced and is on the verge of a major slowdown in economic activity.

All this may be true, but the same negative attitude prevailed in the previous secular bear markets in the 1930s and 1970s. The 1930s bear market came to an end in 1942 in World War II and there was no certainty about survival let alone economic prosperity. The 1970s bear market ended with the US Federal Reserve chairman Paul Volcker jacking up interest rates and putting the US back into recession. The market took its medicine and marched higher.

It could well be we are entering the final stages of the five-year bear market. I believe the next six months will be highly volatile with economic growth in the US, Europe and China all ratcheting down. The recent industrial production numbers in these economies are a big concern for the short term. This should induce a dive lower by the market, before a recovery can take place. Such a decline should also be swift and take many by surprise.

Just when and what will end this bear market no one knows. However, when the turning point comes the move will be abrupt and most observers will be left stranded, scrambling to get a piece of the action.

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